Cash-Hoarding Japan CEOs Made Index Pariahs in Abe Plan

In Japan, where company strategies
curtail return on equity to half the global average, the
government has a new weapon to shame chief executive officers
into boosting returns: a stock index.

The JPX-Nikkei Index 400, an investment gauge with members
selected for their profitability and use of cash, was started in
Tokyo earlier this month. It’s the brainchild of officials in
Prime Minister Shinzo Abe’s Liberal Democratic Party, who said
they advised Japan Exchange Group Inc. in formulating the
measure after outlining a version in campaign literature
published in 2012. Companies on the broader Topix index posted
an average return on equity of 6 percent over the 10 years
through 2013, compared with 12.6 percent for the MSCI World
Index, data compiled by Bloomberg show.

While Abe makes no mystery of his attempts to engineer
inflation to boost the economy, his foray into indexes is less
well-known, and may be unprecedented in developed markets,
according to Sumitomo Mitsui Trust Holdings Inc. The JPX-Nikkei
400 was devised to prod Japan’s biggest public retirement fund
into putting more of its 124 trillion yen ($1.2 trillion) in
stocks, SMBC Nikko Capital Markets Ltd. said.

“I’ve never heard of anything like this happening anywhere
else,” said Ayako Sera, a Tokyo-based market strategist at
Sumitomo Mitsui Trust Holdings, which has the equivalent of $651
billion in assets. “It sounds like something that would happen
in China, where government control runs deep,” she said. “It’s
very shady.”

LDP Manifesto

Indexes matter because institutional investors as well as
government bodies buy stocks they include in order to tie
returns to the success of a broad swathe of the economy. The
buying can increase the value of those companies, allowing them
to raise more capital for expansion.

JPX-Nikkei 400 members are chosen based on return on equity
and cumulative operating profit, which each account for 40
percent of the selection criteria. Market value makes up the
remaining 20 percent. Companies that don’t meet corporate-governance criteria may be replaced.

Even after the Nikkei 225 Stock Average (NKY), one of two
benchmarks for the broader Japanese market, surged 57 percent
last year for the biggest gain since 1972, designers tossed out
about one-third of its constituents when compiling the JPX-Nikkei 400.

Rejects included Panasonic Corp. (6752), which is restructuring to
improve profits after record losses, Olympus Corp., an endoscope
and camera maker whose accounting fraud led to a revamp of its
board, and Tokyo Electric Power Co., the utility at the center
of the biggest nuclear accident since Chernobyl.

Two Objectives

“Being chosen for the JPX-Nikkei 400 will be like getting
a certificate from the government,” said Kiyoshi Yamanaka,
executive officer for T&D Asset Management Co. “In the long
term, ROE should improve as companies who were not chosen for
the index, and who care about how investors see them, try to get
onto the measure.”

An LDP policy paper titled J-File 2012, released Nov. 27,
2012, proposed using a share index to influence corporate
priorities and improve the competitiveness of public investment
funds. The Tokyo Stock Exchange should design a 300-company
measure tied to factors such as ROE and corporate governance,
according to a party document expanding on the plan in May.

While Atsushi Saito, the chief executive officer of Japan
Exchange Group, said the Tokyo exchange owner and Nikkei Inc.,
its partner in publishing the index, came up with the idea
themselves, that’s not the whole story, according to Yasuhisa Shiozaki, the deputy policy chief for the LDP.

“It was us,” he said in an interview on Jan. 21. “They
said 500 companies at first,” while the LDP suggested 300, “so
they took the middle ground and chose 400,” Shiozaki said.

Record Cash

The index’s first goal is to change the behavior of
Japanese companies by creating an incentive to boost profit
margins and avoid holding too much cash, according to Jonathan Allum, a London-based strategist at SMBC Nikko Capital Markets.
The second is to get big investors such as the Government
Pension Investment Fund to put more of their holdings into the
stock market, rather than government bonds, he said.

Return on equity at Japanese companies in the 10 years
through 2013 has been among the lowest of 24 developed markets
tracked by Bloomberg. The Topix’s average was 6 percent, beating
only Greece’s ASE Index, data compiled by Bloomberg show.
Companies in the Standard & Poor’s 500 Index delivered 13.6
percent, while the Stoxx Europe 600 Index returned 13 percent
and the MSCI World Index’s average ROE was 12.6 percent, the
data show.

Business Values

Japanese corporations’ low returns are rooted in business
values, said Naoki Kamiyama, chief equity strategist in Tokyo at
Bank of America Corp.’s Merrill Lynch unit. Companies sacrifice
profits to increase market share and hoard cash as a buffer
against bad times.

Profit margins, or the difference between sales and
expenses, average just over 4 percent for companies in the
Topix, compared with 9 percent for the S&P 500, Bloomberg-compiled data show. Japanese companies’ cash holdings rose to a
record 224 trillion yen ($2.17 trillion) in the third quarter,
almost the size of Russia’s economy, according to a Bank of
Japan report released Dec. 19.

Japan’s 10-year government bonds yield 0.64 percent, the
lowest rate in the world, while retirement costs for the world’s
oldest population are rising. The Government Pension Investment
Fund, or GPIF, owned 71.9 trillion yen in domestic debt as of
Sept. 30, making up 58 percent of its assets, it said in its
quarterly report.

Share Performance

“If GPIF takes the initiative and uses this index for a
large amount of investments, the move itself could improve the
share performance of the constituent companies,” said Bank of
America Merrill Lynch’s Kamiyama. “If everyone starts investing
in this index they can start pointing fingers at the companies
without high ROE. I think it’s correct for the government to use
policy to try to change people’s behavior.”

A panel appointed by Abe to advise the government on how to
overhaul GPIF said it should increase investments in riskier
assets and consider using the new measure for equity investments
instead of the Topix, which “includes stocks lacking sufficient
investment profitability.”

GPIF President Takahiro Mitani said last month the fund is
“still considering” whether to use the JPX-Nikkei 400 as its
benchmark. ROE for companies in the JPX-Nikkei 400 averaged 11.1
percent over three years, almost twice the 5.7 percent average
for the Topix, Japan Exchange and Nikkei said in November.

Investors are waiting to see whether GPIF will put money in
the new index before deciding to adopt it themselves, according
to Tomomi Yamashita, who helps oversee 639 billion yen at
Shinkin Asset Management Co. in Tokyo.

Strategist Doubts

“I’m still watching as the pension funds haven’t decided
to use JPX-Nikkei 400 yet,” he said. “If GPIF starts using it
as a benchmark, then other pension funds will follow.”

Strategists are skeptical the JPX-Nikkei 400 will achieve
the government’s aims.

For SMBC Nikko’s Allum, any index tends to promote passive
investment, “regardless of what’s in it.” The JPX-Nikkei 400
also selects companies based on return on equity without
considering their valuations, he said.

“Buying high-ROE stocks isn’t necessarily a good strategy
in itself,” Allum said. “Investment is about quality versus
value. Being included in the index is a badge of honor for the
company. But for the investor, you may end up buying cyclical
stocks at the top of the cycle.”

The ruling party shouldn’t be attempting to change anyone’s
behavior using a stock benchmark, according to Sumitomo Mitsui
Trust’s Sera.

‘Less Sway’

“The government should do other things to improve
corporate performance,” she said. “Not create an index, but
something that’s actually part of economic policy, such as
lowering corporate tax rates or easing regulations -- something
a normal government would do.”

Equity owners have less sway in Japan than in Europe or the
U.S., with the needs of employees, business partners and other
stakeholders seen as equally important, said Peter Elston, the
Singapore-based head of Asia-Pacific strategy at Aberdeen Asset
Management Plc., which oversees $321 billion.

“Everyone talks about Japan having experienced two lost
decades, but actually if you were a girl working the elevator in
a department store, it wasn’t a lost decade for you because you
kept your job,” Elston said. “That is at the expense of
profitability and the expense of minority shareholders.”

First Month

In its first month of trading, the JPX-Nikkei 400 has
produced the same result for investors as the Topix, with both
gauges falling 6 percent. The Nikkei 225 decreased 7.9 percent
over the period.

The JPX-Nikkei 400 fell 2.5 percent to 11,063.66 at the
close of trading in Tokyo today, while the Topix slipped 2.6
percent to 1,224.09 and the Nikkei 225 lost 2.4 percent to
15,007.06.

The JPX-Nikkei 400 is aligned with plans by Abe and Bank of
Japan Governor Haruhiko Kuroda to end 15 years of deflation,
according to Resona Bank Ltd., Japan’s fifth-largest lender by
market value.

“Too many companies in Japan have poor profitability, but
deflation and an extremely strong yen gave them no choice but to
tolerate lower margins to compete globally,” said Koji Toda,
chief fund manager who helps manage about 18 trillion yen at the
Tokyo-based bank. “If Abenomics continues to weaken the yen and
spur higher prices, ROE and profits will begin to recover.”

Yen, Inflation

Japan’s currency has fallen about 19 percent against the
dollar since Abe came to power in December 2012. Inflation in
the nation accelerated in November at the fastest pace since
2008. Consumer prices excluding fresh food rose 1.2 percent from
a year earlier, government figures Dec. 27 showed.

“It is odd when the government gets involved in the
construction of a stock index,” Neil Azous, founder of Rareview
Macro LLC, a Stamford, Connecticut-based advisory and research
firm, said in a Jan. 21 interview. That’s not true in Japan,
“where the lines have already been blurred by the co-mingling
of monetary and fiscal policy,” he said.

Abe will be hoping the JPX-Nikkei 400 succeeds in its
goals, as sustaining the rally in Japanese equities will be
critical to his approval ratings, according to Jeff Kingston,
director of Asian Studies at Temple University in Tokyo.

“Most people assessing the impact of Abenomics see the
stock market as the best public barometer for how it’s
working,” Kingston said. “The market isn’t something he can
afford to neglect.”